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Dear Sir,
I’m having trouble calculating the cost of equity and cost of capital via the ungearing and gearing methods to arrive at what the examiner arrived at via the MM formula.
So if I calculate the ungeared Beta based on 12.46%, do I still use the same debt-equity ratio of 20:80 also for this calculation?
Then I calculate the geared Beta using the 20:80 ratio and ungeared Beta calculated from above.
Then to calculate the cost of equity, I use the 4.50% as the risk-free rate?
Many thanks for your help,
JustineYes to everything above (and presumably you ended up with the same cost of capital?) 🙂
(But remember that the cost of debt in the cost of capital calculation is not 4.5% but is 4.5% less tax of 18%).
For some reason I can’t get the cost of capital to be the same
For the ungeared Beta, I calculated: (0.80/0.8+0.20×0.82)×0.1246) = 0.10340
But if I use this and the same 80:20 ratio to calculate the geared Beta, I end up with the Beta just being 0.1246 which makes me think I’ve done something wrong?
But you cannot calculate the beta because you do not know the return from the market.
If you do it this way then you need to use algebra. Assume the return from the market is M.The 12.46 = 4.5 + Beta (M – 4.5)
Therefore beta = 7.96 / (M – 4.5)Now use the asset beta formula:
7.96 / (M – 4.5) = (80 / (80 + 16.4)) Beta equity
So Beta equity = 9.5918 / (M – 4.5)
Therefore cost of equity = 4.5 + (9.5918 / (M – 4.5)) x (M – 4.5)
= 0.140918Sir you are a legend! I totally used the 12.46% in the wrong way. Makes sense now. Thank you very much!
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